Safe Harbor 401(k) Plan Design

Being the bearer of bad news isn’t fun.

When the third-party administration firm relays that aspects of the annual compliance testing have failed causing many of the company’s executives to receive taxable distributions from the plan, it isn’t a great day for the HR manager. The administrator explains that the regulations require testing to prevent highly paid employees from receiving disproportionately greater benefits than other employees. At a much-needed lunch that day, the HR manager learns from a colleague that they once had the same issue but adopted a “safe harbor” design to solve the problem.

In their 61st Annual Survey of Profit Sharing and 401(k) Plans, the Plan Sponsor Council of America reports that, of the 605 plan sponsor respondents to the survey, 42% reported using a safe harbor design. Since December 1st, 2019 marks the last day to make a safe harbor election for 2020 calendar year plans, understanding the pros and cons of these elections will help you decide if a safe harbor design is the right choice for your plan.

Each year in a non-safe harbor plan, a series of nondiscrimination tests are performed to demonstrate that the contribution rates for highly compensated employees (HCEs) are not disproportionately larger than those for non-HCEs (NHCEs). HCEs are generally owners of more than 5% of the company and any employee with compensation in the prior plan year over a specified level ($125,000 for 2019). If a plan elects to be “safe harbor” for any given year, the compliance testing can be avoided by meeting the safe harbor standards. One of the main reasons for adopting a safe harbor design is to allow HCEs to defer up to the maximum dollar limit ($19,000 for 2019) without the potential limitation of the participation rate of the NHCE group.

So, what’s the trade off? In order to satisfy a safe harbor election, the employer is required to comply with safe harbor standards which include the following:

• Contribute an employer match or nonelective contribution that satisfies safe harbor requirements. Several matching formulas can qualify but none less than 100% of the first 3% of salary deferred plus 50% of the next 2% deferred (4% total). A non-elective contribution can also be selected which must be at least 3% of pay to all eligible NHCEs. Though not required, the contribution can be made on behalf of HCEs as well.
• The contributions used to satisfy the safe harbor plus any gains must be 100% vested at all times.
• Annually, a notice must be issued to participants announcing the plan’s intent to comply with safe harbor provisions for the upcoming year. The notice must contain the basic features of the plan and must be distributed 30 to 90 days prior to the beginning of the plan year for which safe harbor provisions will be implemented. So, for a calendar year plan to elect safe harbor for 2020, notice must be given to participants no later than December 1, 2019.

Does your plan include an automatic enrollment feature? If so, a modified version of the safe harbor plan is available for you. The rules for so-called Qualified Automatic Contribution Arrangements (QACA) are similar to the regular safe harbor rules, except that the QACA matching requirement is 100% of the first 1% of compensation deferred, plus 50% of the next 5% of compensation deferred (maximum match of 3.5%). In addition, safe harbor contributions under the QACA must be 100% vested after two years of service rather than the immediate vesting required of traditional safe harbor plans. The participant notice must contain additional information describing the automatic enrollment features.

A safe harbor design is an excellent way for many employers to get the most out of their 401(k) plans. By eliminating nondiscrimination testing, all employees can contribute up to the annual deferral limit and not be concerned about the possibility of refunds after year-end. If you think a safe harbor option is right for your plan, contact us.